Everything You Always Wanted to Know About The Child IRA
(This is the first in a series of three installments.)
Beginning in the winter of 2014, a series of articles came out that represent the beginnings of a concept called “The Child IRA.” The following series of articles will answer the most asked questions about The Child IRA. First, we’ll explain numbers behind what makes The Child IRA so attractive and some variations that allow it to be replicated. Next, we’ll explore what’s required to create and contribute to The Child IRA under current laws, including why those variations may be more achievable than the original. Finally, we’ll review some real world examples of The Child IRA in action, including a twist that you might have overlooked.
Summary of The Child IRA
The genesis of The Child IRA began with the article “What Every 401k Plan Sponsor and Fiduciary Should Disclose to Employees: How to Retire a Millionaire (Hint: It’s Easier Than You Think),” (FiduciaryNews.com, February 25, 2014). This piece discusses an approach commonly used in 401k education sessions to persuade employees to begin saving as early as possible. It compares a 15-year old saving $1,000 a year for sixteen years vs. a 40-year old saving $5,000 for the same time period. Assuming they each retire at age 70, the younger saver finds he has nearly three-quarters of a million dollars while the older saver has only a little more than half a million dollars. This despite the 40-year old saves five times more than the 15-year old.
A spreadsheet accident led to a follow-up article, the first to mention the phrase “The Child IRA.” In the course of running the numbers of the first article, the age was inadvertently reset to zero instead of fifteen. The almost penicillin-like serendipity led to the publication of the article “This idea will solve the retirement crisis, guaranteed!?” (BenefitsPro, February 26, 2014). By dialing back the start age to “new born baby” and investing that $1,000 annually until said baby reaches age 19, we find the value of The Child IRA will have grown to two-and-a-quarter million dollars. That’s right. For the price of a $19,000 investment, the “child” in The Child IRA becomes a multi-millionaire when they retire at 70. Said another way, for about the cost of dinner for two each month (per Zagat’s 2015 Dining Trends Survey), or the cost of a family meal at McDonald’s once a week, or less than the cost of that daily Vanilla Bean Crème Frappuccino at Starbucks, parents can help set their child on the path to a quite comfortable retirement.
With that in mind, it quickly became apparent The Child IRA could easily obviate the need for Social Security. “It’s time we create a Child IRA,” (Benefit Selling, April 2014) explains, in numerical detail, how The Child IRA can become a viable national policy to eventually replace Social Security. Finally, the entire notion of The Child IRA was fleshed out and repurposed to become Appendix V in the book Hey! What’s My Number? – How to Improve The Odds You Will Retire in Comfort, (Christopher Carosa, 2014, Pandamensional Solutions).
About the Assumptions Used with The Child IRA
The first major assumption is the return assumption used in the 70-year period encompassing The Child IRA. The number used is 8%. This is roughly 3% less than the 11.04% median return for the nineteen 70-year rolling periods from 1928 through 2015 (based on the Stern-NYU annual return data for the S&P 500). Moreover, it is more than 2% less than the worst performing 70-year rolling period (10.21%). This cushion is more than enough to account for account fees, timing of cash flows, and sequence of return risk.
Despite the conservative nature of the return assumption, it’s best to view the $2.25 million end result as a good “approximation.” It’s also important to remember this retirement fund does not include retirement savings made by the child during their working adult years. As the article from Benefits Selling Magazine concludes, it’s a great “head start.”
The second major assumption deals with the $1,000 annual contribution. This begins from the year the baby is born and ends when that child turns nineteen. There are two important considerations with this assumption. First, in the real world, given the opportunity most would maximize the annual contribution (currently $5,500) and not limit themselves to only a fraction of that. The $1,000 annual contribution used in our example is meant to show how easy it would be to establish and maintain The Child IRA. In addition, it demonstrates how a small sacrifice (one Frappuccino a day) can yield a return of huge magnitude (to the tune of two-and-a-quarter million).
As we’ll learn in a later installment, several obstacles stand in the way before one can take advantage of The Child IRA. For one, it applies only to new born babies. But, can older children also avail themselves to The Child IRA? The quick answer is “yes.” This is the benefit of not relying on the maximum available contribution. In fact, as Chart I. “Catching Up to The Child IRA” illustrates, the entire shortfall can be made up in the first year’s contribution up until age 4. Indeed, by utilizing the annual maximum, one can “catch-up” by starting at any age up to and including age 12. Once you start at ages 13 and older, you’ll need to make contributions beyond age 18. For example, to achieve the same end result when starting at age 18, you’ll need to contribute the maximum $5,500 until age 27 and then another $3,434 at age 28.
Chart I. “Catching Up to The Child IRA”
(Annual Contribution Rates to Yield the Same Result at Age 70)
The Child IRA for College Aged Children?
The Child IRA also works for college aged children, (although by that age, The Child IRA is nothing more than a regular IRA). We won’t dwell too much on this because the circumstances have been addressed many times before as justification for starting an IRA. For the purposes of comparative continuity, however, we’ll share with you the numbers in terms of achieving the same results as The Child IRA. For example, to reap the same $2.25 million reward as The Child IRA, a 19-year who begins saving $5,500 a year must contribute that same amount through age 30. If the college student waits until age 22 to start, maximum contributions must be made every year until age 39, then another $2,881 must be made at age 40.
At the very least, The Child IRA for college aged children validates the power of compounding.
Are you interested in discovering more about issues confronting 401k fiduciaries? If you buy Mr. Carosa’s book 401(k) Fiduciary Solutions, you’ll have at your fingertips a valuable reference covering the wide spectrum of How-To’s (including information on the new wave of plan designs) every 401k plan sponsor and service provider wants and needs to know. Alternatively, would you like to help plan participants create better savings strategies? You can buy Mr. Carosa’s latest book Hey! What’s My Number? How to Improve the Odds You Will Retire in Comfort right now at your favorite on-line or neighborhood book store.
Mr. Carosa is available for keynote speaking engagements, especially in venues located in the Northeast, MidAtantic and Midwestern regions of the United States and in the Toronto region of Canada.